cost of capital
TRANSCRIPT
Cost of Capital 13-2
© morevalue.com, 1997
1 OBJECTIVE
## Managing the right-hand-side of the B/S
## By now, for valuation analysis, we know:! criteria: NPV, IRR, payback! what the relevant CFs are! how to compute net CFs! how to introduce forecast error in CFs (WHAT IF,. . . )
## Sources of financing:Debt, equity, retained earnings, preferred stock, warrants, venturecapital, and bank loans, strategic alliances.
! Bank loans, venture capital, and warrants not discussed
! To simplify, we concentrate only on debt, equity, and retainedearnings.
## Cost of financing = cost of capital = ?! Definition: The rate that must be earned to satisfy the
required rate of return of the firm's investors.
! What is the cost of each source of financing?
! What is a project's cost of capital?
# Why might cost of capital in Japan be lower than in U.S.?
Alex Tajirian
Cost of Capital 13-3
© morevalue.com, 1997
2 MOTIVATION
2.1 WHY IS COST OF CAPITAL IMPORTANT?
If financing cost is reduced Y NPV increases Y more projects endup with NPV > 0 Y more wealth created to shareholders.
2.2 SOME PRELIMINARIES! Minimum required return / cost of capital= that particular
discount rate “k” that makes NPV = 0.
! The return generated by a security is the cost of that securityto the company that issued it. ] cost of capital to the firm = reward to investors.
! The cost of capital depends primarily on the use of funds, i.e.,the risk of the CFs, not on the source.Q risk of CFs (systematic risk)Q company capital structure
Alex Tajirian
Cost of Capital 13-4
© morevalue.com, 1997
2.3 COST COMPONENTSCase 1 Assume firm has no debt & has retained earnings.
Remember from the chapter on Performance Measures: Net Income = total dividend + retained earnings
If a company cannot find profitable projects, i.e., projects with returnat least equal to ks , then the firm should distribute retained earningsto shareholders as dividends.
Thus, if the company is retaining your money, then the minimumacceptable reward to you (an average investor) is the required returnon equity Y required return on retained earnings = ks / requiredreturn on equity.
But reward to investor = cost of capital to the firm.
ˆ required return on equity = cost of retained earnings.
Case 2Now suppose firm needs to issue new equity for an expansionproject. Obviously
ke > ks ] (cost of new equity) > (cost of retained earnings) ](required return on new equity) > (required return on retainedearnings)
since some transactions (floatation) costs have to be paid toinvestment banks for assisting firm in selling the new securities.
Alex Tajirian
Cost of Capital 13-5
© morevalue.com, 1997
Case 3If a company has a "good" project (NPV > 0), should it be financedusing equity?
Not necessarily, firm should consider using debt.
2.4 OUTLINEGiven a company's target capital structure, Step 1: Estimate cost of each componentStep 2: Calculate the cost of the combination of financing
sources, i.e., company WACC
Alex Tajirian
Cost of Capital 13-6
© morevalue.com, 1997
WACC ' sum of weighted rewards to firm )s capital providers
' wd(cost of debt) % ws(cost of equity)
where, wd 'Debt
Assets'
DebtDebt % Equity
ws 'Equity
Debt % Equity, and wd % ws ' 1
In general,
where,WACC = Weighted Average Cost of Capital.
Debt = Market value of the company’s debt
Equity = market value of the company’s equity
wi = the weights (proportions) of each source of capital,based on the company’s optimal/target financingmix (capital structure).
Notes.(a) It is not the source of financing that
determined the cost of capital.(b) B/S weights need not be reflective of market
values.(c) Weights are based on the optimal company’s
source of financing; the topic of next chapter.
Alex Tajirian
Cost of Capital 13-7
© morevalue.com, 1997
CALCULATING COST OF EACH COMPONENT
We first start with the cost of each source of new capital, then taketheir weighted average. Note, the weights are given by the optimalcapital structure.
2.5 COST OF RETAINED EARNINGS, ksLL Cost of retained earnings = required rate of return on equity
? What are possible approaches to estimate ks
Alex Tajirian
Cost of Capital 13-8
© morevalue.com, 1997
ks ' kRF % (kM & kRF)$s
' 7.0% % (8.5%)(.847)' 14.2%
Example: Calculating Cost of Retained EarningsGiven: kRF = 7% Dividend0 = $4.19
kM - kRF = 8.5% P0 = $50$ = 0.847 g = 5%
ks = ?
Solution:
L Two approaches when company stock is trading on an exchange:
# 2.5.1 CAPM Approach
Alex Tajirian
Cost of Capital 13-9
© morevalue.com, 1997
ks 'Dividend1
P0
% g 7
'Dividend0 × (1 % g)
P0
% g
'4.19 × (1.05)
$50% .05
' 0.088 % 0.05 ' 13.8%
## 2.5.2 DCF Approach:
Given: Dividend0 = $4.19, g = 5%, p0 = $50ks = ?
Solution:
From equation (4) chapter 7, we have:
ˆ̂ You can use the average of these two approaches = 14%.
Alex Tajirian
Cost of Capital 13-10
© morevalue.com, 1997
2.6 COST OF NEWLY ISSUED COMMON STOCK, ke# Floatation costs (F) are not part of capital budgeting CFS. Thus, if
existing shareholders finance projects using new equity, they requirea higher return to cover this cost YY ke > ks .
# If P0 = $50 and F = 15% of issue price, then additional cost per share= (50)(15%) = $7.5.
Alex Tajirian
Cost of Capital 13-11
© morevalue.com, 1997
ke 'Dividend1
net value of new equity per share% g
'Dividend1
issue price & floatation cost% g
'Dividend1
P0 & (P0)(F)% g
'Dividend0 × (1%g)
P0(1&F)% g
'$4.19 × (1.05)
$50(1& .15)% .05 ' 15.4%
Example: Calculating Component Cost of New EquityGiven:
F = 15% of issue price, Dividend0 = 4.19 , g = 5% , P0 = $50ke = ?
Solution:Using equation (4), Chapter 7, and including F, we have:
# Accounting vs. Financial/Economic Valuation
Alex Tajirian
Cost of Capital 13-12
© morevalue.com, 1997
kps 'Dividendps
Pps& F
'$10
$113.1&2.00'
$10$111.1
' 0.09 ' 9.0%
2.7 COST OF PREFERRED STOCK, kps
Given:Dividendps = $10 annually, perpetually paidprice (Pps) = $113.1 per share (market price)F = floatation cost = $2.00 per share
Solution:Using equation (3), from Chapter 7, and including F, we have:
Note. No tax adjustment is needed since preferred dividends arepaid from after-tax income.
Alex Tajirian
Cost of Capital 13-13
© morevalue.com, 1997
2.8 COST OF DEBT = kd (1-T) kd is the interest paid to new bond holders.But since interest is tax deductible Y effective cost of debt = after-tax cost of debt
= before tax cost - tax benefit= kd - T kd×
= kd(1 - T)
Example: Calculating Component Cost of DebtGiven: Semiannual bond; coupon rate = 12%; years to maturity = 15;
price of a similar bond = $1,153.72; T = 40%kd(1-T) = ?
Alex Tajirian
Cost of Capital 13-14
© morevalue.com, 1997
coupon 'coupon interest × par value
2'
12% × $1,0002
' 60
PV ' SUM of discounted CFsY $1,153.75 ' 60(PVIFAk d
2
,30 ) % $1,000(PVIFk d2
,30)
Try k d2
' 6%
Y 60(PVIFA6,30) % 1,000(PVIF6,30)' 60(13.7648) % 1,000(.1741) ' 825.88 % 174.1 ' 999.98
< price ' $1,153.72You have to try a number < 6%, say k d
2
' 4%
Y 60(17.2920)% 1,000(.3083) ' 1,346.35 > price
Solution: Based on formula for PV of bondsStep 1: Calculate semi-annual couponStep 2: Use Trial & Error methodsTrial & Error Method:
If you try kd/2 = 5%, you will get it right.
ˆ̂ kd = 5% x 2 = 10% Y kd(1-T) = 10%(0.6) = 6%
Alex Tajirian
Cost of Capital 13-15
© morevalue.com, 1997
WACC ' wdkd(1&T) % wpskps % wsks % weke
' 0.3(10%)(0.6) % 0.1(9%) % 0.6(14%) % 0' 1.8% % 0.9% % 8.4%' 11.1%
Example: Calculating Company WACC
Given:! optimal proportions are: 30% Debt, 10% Preferred, 60% common
equity! Retained Earnings = $300,000! T = 40%! Value of k from above examples is used.! $ financing needed = $200,000
Solution:If retained earnings are to be used to finance projects, as in thisexample,
? What is the amount raised of each component?
Alex Tajirian
Cost of Capital 13-16
© morevalue.com, 1997
? What is the maximum amount of financing that can be sustainedwithout issuing new equity?
Alex Tajirian
Cost of Capital 13-17
© morevalue.com, 1997
Where do the weights come from?
# Possibilities include:! proportional current book value of each component
! proportional current market value of each component
! target capital structure
# Should short-term debt be included in wd?
Alex Tajirian
Cost of Capital 13-18
© morevalue.com, 1997
3 WHAT IS A PROJECT'S COST OF CAPITAL
? Suppose debt = 0 and project is financed through 100% equity.Should firm use ks?
If you use ks, then you are implicitly assuming that the risk ofprojects = risk of company
L Remember: discount rate reflects risk of CFs.
If company has no debt, thenkproject = kRF + (km - kRF)$project
Alex Tajirian
Cost of Capital 13-19
© morevalue.com, 1997
USING COMPANY kVs. Project k
Project risk < firm’s Project risk > firm’s
Reject good projects Accept Bad Projects
Beta
k
firm’sk
risk-free
Alex Tajirian
Cost of Capital 13-20
© morevalue.com, 1997
3.1 Project Required Return (k project) and NPV.
if and
implication of usingNPVWACC
projectrisk
$ Companyrisk
Y(kproject - WACC) NPVproject NPVWACC
yes
yes
No
No
+
+
-
-
- + accepting bad projects
+ + no problem
+ - rejecting good projects
- - no problem
NPVproject = NPV using k project as the discount rate
NPVWACC = NPV using company WACC as the discount rate
L use k = kproject to appropriately incorporate project CF-risk
Alex Tajirian
Cost of Capital 13-21
© morevalue.com, 1997
3.2 PROJECT COST OF CAPITAL IN PRACTICE.
! To incorporate risk of CFS, companies have adopted a "crude" wayof calculating kproject. The "hurdle rate" is one such method. It reflectsboth project risk and cost of capital.
hurdle rate = company WACC ± risk premium
! Assume company WACC = 15%,
hurdle rates
project category discount rate (k) risk premium
speculative venture 30% 15%
new product 25% 10%
expansion of existingbusiness
15% 0
cost of improvement,known technology
10% -5%
Alex Tajirian
Cost of Capital 13-22
© morevalue.com, 1997
PROJECT COST OF CAPITAL
Does FirmHave Debt?
Is Project SameRisk As Firm?
Is Project SameRisk As Firm?
Use FirmK
Use k ReflectingProject Beta
Use “Hurdle Rate”
Use FirmWACC
No
NoNo
Yes
YesYes
Alex Tajirian
Cost of Capital 13-23
© morevalue.com, 1997
4 COST OF CAPITAL (k) IN JAPAN & U.S.?
Unlike U.S. firms, Japanese firms have traditionally relied more on bankloans as a source of financing. This has enhanced firm monitoring bycreditors (banks). Recently, debt and equity financing has increased.German firms have also traditionally relied more heavily on bank loans.
? Why might the cost be lower in Japan?
# Keiretsu (Companies aligned with financial giants)! Agency problem lower, thus, k is lower
! Floatation cost is low
# Government loans and subsidies, especially for R&D.
Alex Tajirian
Cost of Capital 13-24
© morevalue.com, 1997
T From P0 'Dividend
kY kps '
Dividendps
Pps
Including Floatation costs Y kps 'Dividendps
Pps&F
T From P0 'Dividend1
k&gY k '
Dividend1
P0
% g
including Floatation costs Y ke 'Dividend1
P0(1&F)% g
T WACC ' wdkd(1&T) % weke % wpskps % wsks
5 SUMMARY
TLong-term financing used for long-term projects. Short-term financing is used only if thereis a temporary mismatch between timing of inflows and outflows.
Note. Only debt is tax deductible.
The weights are determined by the target capital structure. The target proportions are notbook values.
Alex Tajirian
Cost of Capital 13-25
© morevalue.com, 1997
6 QUESTIONS
I. Agree/Disagree-Explain
1 If a manager, with no finance background, uses the firm's WACC as the cost of projectfinance, then he/she would be accepting bad projects.
2 A project's cost of capital > company WACC.
3 kd is the cost of debt financing to a firm.
4 Consider the simple case of only two sources of financing, debt and equity. If the target(Debt/Asset) = 0, then a company's WACC = ks.
5 Floatation costs are irrelevant to capital budgeting.
II. What Happens to kd(1-T) and WACC if:a. firm incurs more debtb. interest rates increasec. inflation increasesd. company undertakes risky projectse. tax rates are increased
Alex Tajirian
Cost of Capital 13-26
© morevalue.com, 1997
III. NUMERICAL.
1 WAK Inc. has a cost of equity of 15%, before-tax cost of debt of 10%, and a marginal taxrate of 40%. Its equity and debt are trading at book value.(a) Using its balance sheet data below, calculate WAK's WACC.
Assets Liabilities and Equity
Cash $500
Accounts receivable 300
Inventories 800 Long-term debt $500
Plant and equipment 400 Equity 1,500
Total assets 2,000.00 Total liabilities and equity 2,000.00
(b) How would you calculate WACC if equity and debt were not trading at book values?Also assume that the firm is currently at its target capital structure.
Alex Tajirian
Cost of Capital 13-27
© morevalue.com, 1997
ANSWERS TO QUESTIONS
I. Agree/Disagree-Explain
1 Disagree. It depends on the project's risk. See p. 20.
2 Disagree. Only if the project is more risky than the company.
3 Disagree. Interest is deductible. Thus cost of debt is kd(1-T).
4 Agree. Assuming that the only two components of assets are debt and equity, at (Debt/Asset)= 0, the WACC would have wd = 0 and ws = 1. Thus, WACC = ks.
5 Disagree. Although floatation costs are not part of the relevant CFs, they are part of the costof capital (k). Thus, they do impact capital budgeting decisions.
II. What Happens to kd(1-T) and WACC if:a. firm incurs more debtb. interest rates increasec. inflation increasesd. company undertakes risky projectse. tax rates are increased
Alex Tajirian
Cost of Capital 13-28
© morevalue.com, 1997
wd 'DebtAsset
'500
500%1,500' .25
ws ' 1&wd ' .75
Y WACC ' wdkd(1&T) % wsks
' .25(.10)(.6) % .75(.15) ' 12.75%
III. Problems.1. Step 1: Calculate weights: proportions of each source of capitalStep 2: substitute in WACC equation
Capital Sources Amount
Long-term debt 500
Equity 1,500
2,000
(b) What happens if stock is not trading at book value, i.e., book value is different frommarket value?
Calculate market values of debt and Equity.Debt = Market value of Debt = sum of [(market price of each bond)(# of bonds outstanding)]Equity = Market value of Equity
= (price of stock)(# of shares outstanding)
Thus, the proportions have to be based on market-value proportions, not book valueproportions.
Alex Tajirian